Thursday, February 01, 2007

Good Debt, Bad Debt

Debt is a subject that generates a lot of diverse opinions - for good reason.

My take on debt is that it can be both good and bad and it is not always possible to know in advance whether particular borrowings will be good or bad. I find it instructive that many very successful investors use debt (or use derivatives to achieve leverage) in the course of making investments. Some of them use a lot of debt. When things go well, the results can be spectacular. It is also instructive that many investors who get into financial difficulty do so because they borrowed money for their investments. The results can also be spectacular in a very different way when things go wrong.

Bad Debt

Debt that is not used to invest in assets that produce a return greater than the cost of borrowing is bad debt. It is damaging your financial position.

Good Debt

Debt that is used to invest in assets that produce a return greater than the cost of borrowing is good debt. It is improving your financial position.

Not so simple

The above distinction is simple - too simple. There are a host of factors that complicate matters. The most important (and obvious) of which is risk. It is usually very difficult to know in advance what return an investment will achieve. You may expect an investment to yield a given rate of return but it is rare to have an assurance that the expected rate of return will be achieved. If the actual rate of return is less than the expected rate of return and less than the cost of borrowing then using debt will damage your financial position - reducing the rate of return or increasing losses. There are, of course, many other risks and issues which arise as a result of borrowing.

Managing risk

I use debt. I like using debt on my investments. Use of debt means I can acquire more investments than I would be able to do without the use of other people's money. However, I am cautious and conservative in my use of debt (at least I think I am). My current borrowings all share the following characteristics:

1. they are secured against assets that are unlikely to fluctuate dramatically in value on a daily basis. At present, all borrowings are property related;

2. the assets acquired with borrowings are all ones that produce cash flow. At present, all the properties are rental properties;

3. all borrowings are on principal + interest repayment terms. The amount of equity in each property will build up over time. Eventually, each property will be owned outright;

4. gearing ratios are set at a level where the expected cash flow is greater than the loan payments. This is achieved either by increasing or reducing the equity component of the investment or increasing or reducing the term of the loan. Historically, my initial equity has ranged from 30% to 55% of a property's purchase price and the repayment terms have ranged from 7 to 20 years. In practice things do not always go as planned, but any shortfall in cash flow is likely to be too small to be of any concern;

5. all interest rates are set at the lowest available floating rate I can obtain at the time the loan is negotiated. I have looked into fixed interest loans but, in Hong Kong at least, the cost of fixing the interest rate has always been prohibitively expensive.

In summary, my approach to gearing on property is to use debt to achieve greater returns, but to limit and structure my debt so that, if things do not go as planned, I should be able to simply wait until either the debt is paid off from the rents or the market turns in my favour without feeling under pressure from lenders to accelerate payments or sell assets in unfavourable market conditions.

This approach represents my accepted level of risk in relation to borrowings. It will not put me among the ranks of the world's truly wealthy, but it should keep me away from the bankruptcy courts.